Investor interest in Southeast Asian stock markets--particularly those of Thailand, Indonesia, and the Philippines--has been very strong over the past year, thanks to healthy trends in domestic consumption and capital spending spurred by supportive local fiscal and monetary policies. While the larger emerging-markets economies such as China, India, and Brazil have been posting growth rates somewhat below market expectations, Southeast Asian countries have been growing at or above expectations. Thanks in part to these factors, Southeast Asian stock markets have rallied strongly over the past year, which is evident in the recent performance of market-cap-weighted country funds, such as iShares MSCI Thailand Capped Investable Market (NYSEARCA:THD), iShares MSCI Indonesia Investable Market (NYSEARCA:EIDO), Market Vectors Indonesia Index ETF (NYSEARCA:IDX), and iShares MSCI Philippines Investable Market (NYSEARCA:EPHE).

Click to enlarge - Source: Morningstar Direct

Economists Are Positive, but Increasingly Cautious, on the Region's Prospects The International Monetary Fund, World Bank, and Asian Development Bank have all recently issued fairly consistent growth forecasts and outlooks for the Asian region. All three forecast mid-single-digit GDP growth for the ASEAN-4 (Indonesia, Malaysia, Thailand, and the Philippines) over the next two years, driven by strong domestic demand and infrastructure investment, growth in intraregional trade, and an improving external demand environment, which will be positive for the more export-oriented economies. Unemployment remains low and wages are rising.

That said, these agencies are concerned about possible bubbles forming in the region. Aside from the market rally, there are other potentially concerning trends. According to the Bank of Thailand, domestic household debt has been increasing at a 15% to 20% annual rate over the past three years. The Bank has also stated that there may be incipient signs of speculation in the local property market. The Thai baht hit a 16-year high against the U.S. dollar in April, thanks to strong foreign direct investment and foreign portfolio (equity and debt) inflows. The Philippines and Indonesia are experiencing similar trends in credit growth and property prices. The Philippines saw a further boost in its local currency following a recent sovereign debt rating upgrade to investment grade by two credit agencies. However, bucking the regional trend, Indonesia’s currency has been falling against the U.S. dollar as the nation’s current accounts deficit has grown and commodity exports have fallen. While inflation in the region currently remains moderate, an unexpected acceleration in the global recovery could quickly stoke inflation, as many Southeast Asian economies are operating close to capacity.

But at this time, the potential buildup of financial imbalances stemming from rapid credit growth and rising asset prices has generally not been large enough to be of immediate concern, according to the IMF. Furthermore, the IMF has stated that prices in housing, equity, and credit markets have yet to reach overheated territory relative to 2000 to 2012 averages.

In addition, the Southeast Asian economies have come a long way since the 1997 Asian financial crisis. Government budgets have been healthy, which has given ASEAN-4 countries more scope to stimulate their economies through fiscal expansion. Banks and corporate balance sheets are generally sound and have far less exposure to foreign currency denominated debt, which was one of the main triggers of the 1997 crisis. Local currency debt markets have grown over 16% annually over the last decade, according to the Asian Development Bank. While this development has allowed local governments and corporates to borrow in local currency and at longer maturities, these more robust local currency bond markets also serve as a conduit for volatile capital flows. Although there were initially large capital outflows from the region during the 2008 global financial crisis, there was never any threat of a banking or currency crisis, and the region’s economies and financial systems remained resilient. According to the World Bank, in 2012, Malaysia, the Philippines and Thailand each increased their international reserves by $6 billion. Indonesia increased its reserves by $3 billion. These moves should help these countries better cope with the impact of sudden capital outflows.

Fund Inflows Likely to Sustain Momentum IShares MSCI Philippines Investable Market, iShares MSCI Thailand Capped Investable Market, iShares MSCI Indonesia Investable Market, and Market Vectors Indonesia are all currently exhibiting very strong momentum. This momentum is likely to continue in the near term, thanks to healthy economic fundamentals, further supported by quantitative easing in the U.S. and Europe, and now Japan, which is driving foreign fund inflows. The World Bank estimates that gross capital flows (equity, bond, and bank loans) into the entire Asia ex-Japan region rose strongly to $46.8 billion in the first quarter of 2013, up 86.3% from a year ago, with equity flows more than doubling to $13.2 billion. Net portfolio investment in 2012 (equity and debt instruments) more than doubled to 6.4% of GDP in Malaysia and 1% of GDP in Indonesia, and increased by a third to 1.3% of GDP in Thailand, thanks to considerable capital inflows.

But what about valuations? The Philippines looks expensive on a trailing 12-month price/earnings ratio, both on an absolute and relative basis. The other ASEAN markets also look expensive relative to recent history, but most (save the Philippines) appear fairly valued relative to the S&P 500.

Click to enlarge - Source: Morningstar Direct

Investing in single-country emerging-markets stock funds is best suited for very risk-tolerant investors. While there is strong momentum in the Philippines, Thailand, and Indonesia, current valuations suggest investing in these markets at this time may be more of a short- to medium-term trade. We recommend investors carefully monitor global risk sentiment (during periods of high volatility, investors tend to sell off riskier assets such as emerging-markets securities) and local market fundamentals, particularly inflation trends and rising property prices.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.